Why America Should Stop Worrying and Love Taxmageddon

A decade ago, President Bush passed temporary tax cuts, betting that they would have to be made permanent to avoid an unpopular tax "increase." Everything is going according to schedule.

In 2001, President George W. Bush used the budget surpluses of the late Clinton years -- and a slowing economy that would eliminate those surpluses -- to justify the Economic Growth and Tax Relief Reconciliation Act, which cut income tax rates and phased out the estate tax. Two years later, Tom DeLay used the impending Iraq War to rationalize the Jobs and Growth Tax Relief Reconciliation Act ("Nothing is more important in the face of a war than cutting taxes"), which slashed tax rates on capital gains and dividends.

The key word in the names of those bills is "Reconciliation." Both were passed through the reconciliation process to avoid the need for sixty votes in the Senate, and therefore both could not be permanent. Instead, all of the tax cuts were scheduled to "sunset" at different times, with many expiring at the end of 2010.

TEMPORARY TAX CUTS FOREVER!

That was clearly not the plan, however. President Bush and his advisers believed that the public would never give up a tax cut once they had it -- like an entitlement. The president campaigned throughout his tenure to make his signature tax cuts permanent. In 2004, when Congress began extending the tax cuts, Republican Congressman Jim McCrery said, "Anyone voting 'no' is voting for a tax increase for the American people, especially the middle class" (Iwan Morgan, The Age of Deficits, p. 229).

In 2005, the major tax cuts on investment income were extended by the Tax Increase Prevention and Reconciliation Act. The strategy paid off in 2010 when, despite Democratic control of the White House and both houses of Congress, all of the Bush tax cuts were extended for another two years.

That means that the tax cuts are facing expiration again this year. But the original Bush strategy has been wildly successful: Virtually everyone has internalized the idea that the Bush tax cuts are normal and letting them expire would be a huge tax increase. There has recently been an outbreak of articles discussing the economic consequences of this "fiscal cliff" or "Taxmageddon", including both the expiration of the tax cuts and the automatic sequesters required by the August 2011 debt ceiling agreement.

What is particularly clever about this strategy is that the people who would ordinarily oppose major tax cuts that overwhelmingly favor the rich -- liberals and other Democrats -- are the same people who worry that a tax increase would provide a negative shock to the economy, reducing growth and increasing unemployment. At the same time, the people who would ordinarily favor austerity -- conservatives and other Republicans -- like their tax cuts more than they care about reducing deficits.

So we've reached the point where Democrats have become enamored of the Bush tax cuts. Sure, President Obama wants to eliminate them for the rich, but that's a political point more than anything else. Preserving the tax cuts for the "middle class" (since when is a family making $241,000 middle class?) will cost almost as much as preserving them for everyone.

TAXPOCALYPSE NOW, PLEASE

Here are five reasons not to fall for the now-conventional wisdom.

First, if ending the Bush tax cuts will cripple economic growth, then the Bush tax cuts should have super-powered economic growth in the first place. Clearly, no Democrats were arguing that in 2001 or 2003. And what happened? Here's annual change in GDP before and after the tax cuts.

Yes, GDP growth increased from 2001 (a recession year) to 2004. But tax changes are supposed to have permanent effects (that's the supply-side theory, anyway), and average growth was lower after the tax cuts than before, even leaving aside the financial crisis.

Second, as most Democrats never tire of saying, tax cuts have a lower multiplier than spending increases -- especially tax cuts for the rich, who have a lower marginal propensity to consume (and who are more likely to do their marginal consumption overseas). So if we care about economic growth in the short term, then what we really need are things like extended unemployment benefits, payroll tax cuts, or good old-fashioned spending -- not more income tax cuts.

Third, tax cuts are bad for the middle class. This was a staple of Democratic economic analysis during the Bush administration. For example, in 2004, William Gale and Peter Orszag showed that if you take into account the fact that tax cuts must be paid for eventually (either through spending cuts or tax increases), the Bush tax cuts are bad for everyone except the top income quintile. If you make the relatively realistic assumption that the tax cuts will be paid for by proportional financing (everyone's cash income goes down by the same percentage, whether through lower transfers and services or higher taxes), the only beneficiaries are the top 1% (Table 3).

Fourth, in 2010, the CBO said that extending the tax cuts, while good for the economy in the short term, would be bad in the long term. Making the "middle class" tax cuts permanent would increase GNP by 0.5-1.5 percent over the first two years (Table 3; that's additional growth of 0.2-0.7 percentage points per year) but would make it 0.9-1.3 percent smaller after a decade (Table 4)--even without assuming any policy changes to pay for the tax cuts.

Fifth, while eliminating the Bush tax cuts would not solve our long-term debt problems, it would buy us a little over a decade. That's one decade less of pressure to slash Medicare and Social Security--a longtime conservative goal that only becomes mentionable when we face large deficits.

For these reasons, we argued in White House Burning that the Bush tax cuts should be allowed to expire. All that said, you could still make a case that we need to extend them temporarily because of their short-term Keynesian effects. But the case is nowhere near as clear as all this talk of Taxmageddon would have you believe.

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